Thursday, August 16, 2007

As was to be expected, the bond rating agencies are catching a lot of (deserved) flack over their (abysmal) performance in the subprime mortgage mess (see here). But then again, what else is new? Ratings have been lagging indicators for as long as I can remember. After every crisis --Mexican, Asian, Russian, Enron, etc.--there's been an outcry over why S&P, Moody's and Fitch where asleep at the wheel.

The answer is obvious: incentives. Issuers pay for ratings. Thus, the agencies have a vested interest in being as nice to them as possible to keep the fees rolling in (this Portafolio piece describes this point well). As Barry Ritholtz notes, it's fundamentally the same problem that brought disrepute to sell-side research after the dot com bubble burst (if you think things have changed, just read this).

What can be done? Politicians may huff and puff, but research can't be regulated, other than by inserting ever longer and totally useless disclaimers after each report.

The only possible solution is for large institutional investors to bankroll serious buy-side ratings research. Of course, putting this into practice wouldn't be easy, as there are obvious collective action/free rider problems, but they're much smaller than those faced by individual investors (hence the private equity racket). If they can't do this, the same old rotten ratings system will continue after the storm passes and politicians get back to the latest Middle East crisis.

So why haven't they stepped up? Fear of changing a century-old system? Fear of retaliation by issuers and the investment banks (both profit from the current arrangement? Your guess is as good as mine.